THESE DAYS

it seems Wall Street can't stand itself or at least the thought of owning its own stocks.

With the major market indexes either flat or in the red following a brutal April sell-off, there haven't been many sectors hit harder than brokerage stocks. Overall, the Dow Jones Securities Broker Index is down 13% for the year, compared with a 5.4% decline for the Standard & Poor's 500 and a flat performance for the Dow Jones Industrials. In April, the stocks of big-name Wall Street firms such as Merrill Lynch, Goldman Sachs and Morgan Stanley fell 24%, 12% and 16%, respectively.

The sell-off was sparked, in part, by New York State Attorney General Eliot Spitzer's investigation into potential conflicts of interest between Wall Street investment banking and stock research. And with Merrill taking center stage in Spitzer's inquiry, it's not surprising that shares of the nation's biggest securities firm have been beaten down more than any other Wall Street firm's. But with the Securities and Exchange Commission and other state securities regulators now jumping into the fray, it's clear that "Analyst-Gate" is going to be a headache for the entire industry for quite sometime.

It doesn't help matters that the overall stock market continues to struggle. The recession may be over, but a rapid recovery in corporate profits will take time and that's not the kind of news that spurs much stock buying. Thomson Financial/First Call reports that first-quarter earnings for S&P 500 companies declined 11% year-over-year. The good news is that profits at those same companies are supposed to rise for the first time in more than a year during the second quarter. But the 6.8% increase projected by First Call is a far cry from the high-double-digit gains of the 1990s. In fact, some say the slow improvement in profits as well as the lingering fallout from the collapse of Enron could result in a third consecutive down year for the major market indexes, something not seen in decades.

The growling bear market is leading to speculation that, after shedding some 31,000 jobs in 2001, the nation's brokerage firms might have to cut even more particularly if stock trading and investment banking don't pick up soon, says Peter Nerby, a vice president and analyst at Moody's Investors Service. (Moody's is a credit-rating agency that doesn't perform investment-banking services; Nerby doesn't own shares of companies he covers.) One group that might feel the most pain: stock analysts, who earn anywhere from $300,000 to $1 million a year. David Trone, a brokerage analyst with Prudential Securities, predicts that the backlash against Wall Street research will likely lead to a reduction in pay for the analysts who survive. (Prudential doesn't do investment-banking work; Trone doesn't own any brokerage stocks).

Given all of these issues, it's fair to say that brokerage stocks look about as attractive as toxic waste to many investors. "Anytime you talk about lawsuits and investigations it makes me nervous," says Timothy Ghriskey, a principal in Ghriskey Capital, a Connecticut money-management firm. "There is a lot of uncertainty." Ghriskey says the contrarian thing to do would be to buy brokerage stocks, since it's an old mantra on Wall Street to buy a stock when everyone hates it. But Ghriskey says: "The [legal] overhang gives me pause...even if the valuations are screaming at me."

For a comparison of brokerage stock P/Es and recent performances, click here.

But if you're determined to use Wall Street's misfortune as a buying opportunity, you're going to have to make your purchases with care. A cheap valuation alone isn't enough, given all of the uncertainty on the Street. For now, the safest course of action for individual investors might be to stay away from the companies that have the most to lose in the various investigations and lawsuits stocks like Merrill, Goldman, Morgan Stanley, J.P. Morgan Chase and Citigroup, which owns Salomon Smith Barney.

Instead, investors might consider companies that do minimal investment-banking work and generate most of their revenues from either stock trading or asset management. A firm like Charles Schwab, the nation's biggest discount brokerage, might fit the bill. But be wary, even though Schwab is off some 46% from its 52-week high of $21.60, it still trades at a relatively pricey 2002 P/E of 29. Another option is Investment Technology Group, a small electronic-trading operation that caters to institutional investors. We've written about ITG in the past and noted that it's one of the few Wall Street stocks to perform well in good times and bad. For the year, ITG's stock has risen 19% to just over $46, but it too trades at a pricey 2002 P/E of 24.

A risk-adverse investor might want to take a pass on individual brokerage stocks altogether, and instead consider the two main exchange-traded funds that track the performance of the broader financial sector: S&P's Financial Select Sector SPDR fund and Barclay's iShares Dow Jones U.S. Financial Sector Index fund. The Financial SPDR is unchanged for the year, but the iShares Financial ETF is up 4%. ETFs, as they're known, offer a form of diversification because they expose investors to a whole range of stocks in an index or sector. And the best thing about these ETFs is that they aren't limited to brokerage stocks, but also include big commercial banks, regional banks and insurers all of which have tended to outperform the brokers this year. For instance, the iShares Financial ETF includes 285 financial-services stocks meaning that the fund's holding of Merrill Lynch represents just 1.93% of its $124 million in net assets.

An ETF may not be as sexy as owning shares of a Goldman or a Morgan Stanley, but then again no one is talking about suing, much less investigating, an ETF.